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CHAPTER 12
MONOPOLY
O u t l i n e
The Profits of Generosity
A. Most of us use Microsoft Windows to run our computers.
Microsoft isn’t a price taker like the firms in perfect
competition. How does a firm like Microsoft decide the
quantity to produce and the price to charge?
B. Students get lots of price breaks—at the movies,
hairdresser, and on the airlines. Why? How can it be
profit maximizing to offer lower prices to some customers?
I.
Market Power
A. Market power and competition are the two forces that
operate in most markets.
1. Market power is the ability to influence the market,
and in particular the market price, by influencing the
total quantity offered for sale.
2. A monopoly is an industry that produces a good or
service for which no close substitute exists and in
which there is one supplier that is protected from
competition by a barrier preventing the entry of new
firms.
B. How Monopoly Arises
1. A monopoly has two key features:
a) No close substitutes. The absence of any firms
making close substitutes allows the monopolist to
avoid competition in the market.
b) Barriers to entry. Legal or natural constraints that
protect a firm from potential competitors are called
barriers to entry.
2. There are two types of barriers to entry:
a) Legal barriers to entry create a legal monopoly, a
market in which competition and entry are restricted
by the granting of:
i) Public franchise. The exclusive right granted
to a firm to supply a good or service is
called a public franchise. For example, the
U.S. Postal Service has a public franchise to
deliver first-class mail.
ii)
Government license. The government
controls entry into particular occupations,
professions and industries by requiring a
government license. For example, a license is
required to practice law. Licensing doesn’t
always create a monopoly, but it does
restrict competition.
iii)
Patent and copyright. A patent is an
exclusive right granted to the inventor of a
product or service. A copyright is an
exclusive right granted to the author or
composer of a literary, musical, dramatic, or
artistic work. Because these rights can be
sold, patents and copyrights don’t always
create a monopoly, but they do restrict
competition.
b) Natural barriers to entry create a natural monopoly,
which is an industry in which one firm can supply
the entire market at a lower price than two or more
firms can. Figure 12.1 (page 259) shows the average
total cost curve for an electrical power company
that is a natural monopoly.
C. Monopoly Price-Setting Strategies
1. For a monopoly firm to determine the quantity it sells,
it must choose the appropriate price.
2. There are two types of monopoly price-setting
strategies:
a) Price discrimination is the practice of selling
different units of a good or service for different
prices. Many firms price discriminate, but not all
of them are monopoly firms.
b) A single-price monopoly is a firm that must sell each
unit of its output for the same price to all its
customers.
II. A Single-Price Monopoly’s Output and Price Decision
A. Price and Marginal Revenue
1. The demand curve facing a monopoly is the market demand
curve.
2. This demand curve relates the market price at which the
monopoly firm can sell the corresponding quantity of
output. This allows the firm to calculate revenue
measures:
a) Total revenue, TR, is the price, P, multiplied by
the quantity sold, Q.
b) Marginal revenue, MR, is the change in total revenue
resulting from a one-unit increase in the quantity
sold. The key feature of a single-price monopoly is
that marginal revenue is less than price at each
level of output: that is, MR < P.
c) Marginal revenue is less than the price at all
levels of output because the single–price monopoly
firm must lower its price on all units sold to sell
an additional unit of output. The extra revenue
equals the price of that unit sold less the decrease
in price for each of the units it would have sold at
the higher price. The net increase to revenues
amounts to something less than the price of the last
unit sold. Figure 12.2 (page 260) uses a demand
curve to show how these offsetting influences on
total revenues.
B. Marginal Revenue and Elasticity
1. A single-price monopoly’s marginal revenue is related
to the elasticity of demand for its good:
a) If market demand is elastic, a fall in price brings
an increase in total revenue. The rise in revenue
from the increase in quantity sold outweighs the
fall in revenue from the lower price per unit, and
MR is positive.
b) If market demand is inelastic, a fall in price
brings a decrease in total revenue. The rise in
revenue from the increase in quantity sold is
outweighed by the fall in revenue from the lower
price per unit, and MR is negative.
c) If market demand is unit elastic, a fall in price
brings total revenue does not change. The rise in
revenue from the increase in quantity sold equals
the fall in revenue from the lower price per unit,
and MR = 0.
2. Figure 12.3 (page 261) shows the relationship between
elasticity of demand and total revenues for all three
cases.
3. A single-price monopoly never produces an output at
which demand is inelastic. If it did produce such an
output, the firm could increase total revenue, decrease
total cost, and increase economic profit by decreasing
output.
C. Output and Price Decisions
1. The monopoly faces the same types of technology
constraints as the competitive firm, but the monopoly
faces a different market constraint.
a) The monopoly selects the profit-maximizing level of
output in the same manner as a competitive firm,
where MR = MC.
b) The monopoly sets its price at the highest level at
which it can sell the profit-maximizing quantity.
Table 12.1 (page 262) uses a numerical example to
illustrate the profit-maximizing output and price
decision.
2. The monopoly may earn an economic profit, even in the
long run, because the barriers to entry protect the
firm from market entry by competitor firms.
a) Figure 12.4 (page 263) illustrates the profitmaximizing choices of a single-price monopolist.
b) Monopoly is not guaranteed an economic profit. A
profit is received only when price exceeds average
total cost.
III. Single-Price Monopoly and Competition Compared
A. Comparing the same industry under perfect competition and
monopoly reveals the differences in the two types of
market.
B.
Comparing Output and Price
1. Figure 12.5 (page 264) shows the outcomes of perfect
competition and monopoly.
2. The market demand curve, D, in perfect competition is
the demand curve that the firm faces in monopoly.
3. The market supply curve in perfect competition is the
horizontal sum of the individual firm’s marginal cost
curves, S = MC. This curve is the monopoly’s marginal
cost curve.
4.Equilibrium in perfect competition occurs where the
quantity demanded equals the quantity supplied at
quantity QC and price PC.
5. Equilibrium output for a monopoly, QM, occurs where
marginal revenue equals marginal cost, MR = MC.
Equilibrium price for a monopoly, PM, occurs on the
demand curve at the profit-maximizing quantity.
6. Because marginal revenue is less than price at each
output level, QM < QC and PM > PC
7. Compared to perfect competition, monopoly restricts
output and charges a higher price.
B. Efficiency and Comparison
1. Monopoly is inefficient, and Figure 12.6 (page 265)
shows why.
a) The demand curve is the marginal benefit curve, MB,
and the competitive market supply curve is the
marginal cost curve, MC. So competitive equilibrium
is efficient because MB = MC.
b) Monopoly is inefficient because price exceeds
marginal cost so MB > MC.
c) On all output levels for which MB > MC, a deadweight
loss is incurred.
C. Redistribution of Surpluses
Monopoly redistributes a portion of consumer surplus by
changing it to producer surplus.
D. Rent Seeking
1. The social cost of monopoly may exceed the deadweight
loss through an activity called rent seeking, which is
any attempt to capture consumer surplus, producer
surplus, or economic profit.
2. Rent seeking is not confined to a monopoly. There are
two forms of rent seeking activity to pursue monopoly:
a) Buy a monopoly—expend resources seeking out the
opportunity to buy monopoly rights for a price below
the value of the economic profit earned by the
monopoly.
b) Create a monopoly—expend resources seeking political
influence, such as lobbying legislators to provide
preferential market status by restricting domestic
competition or enacting tariffs on imports.
E. Rent-Seeking Equilibrium
1. The resources used in rent seeking can exhaust the
monopoly’s economic profit and leave the monopoly
owner with only a normal profit.
2. Figure 12.7 (page 267) shows the normal profit that
result from rent seeking.
IV. Price Discrimination
A. Price discrimination is the practice of selling different
units of a good or service for different prices.
1. To be able to price discriminate, a monopoly must:
a) Identify and separate different buyer types
b) Sell a product that cannot be resold
2. Price differences that arise from cost differences are
not price discrimination.
B. Price Discrimination and Consumer Surplus
1. Price discrimination converts consumer surplus into
economic profit.
2. A monopoly can discriminate
a) Among units of a good, charging a different price
for each unit sold. Quantity discounts are an
example. (But quantity discounts that reflect lower
costs at higher volumes are not price
discrimination.)
b) Among groups of buyers, charging different buyers
different prices for the same good or service.
(Advance purchase and other restrictions on airline
tickets are an example.)
C. Profiting by Price Discriminating
Figure 12.8 (page 268) and Figure 12.9 (page 269) shows
the same market with a single price and price
discrimination and show how price discrimination converts
consumer surplus into economic profit.
D. Perfect Price Discrimination
1. Perfect price discrimination extracts the entire potential
consumer surplus and converts it to economic profit.
With perfect price discrimination:
a) Economic profit increases above that earned by a
single-price monopoly.
b) Output increases to the quantity at which price
equals marginal cost
c) Deadweight loss is eliminated
2. Figure 12.10 (page 270) shows the outcome with perfect
price discrimination.
E. Efficiency and Rent Seeking with Price Discrimination
1. The more perfectly a monopoly can price discriminate,
the closer its output gets to the competitive output (P
= MC) and the more efficient is the outcome.
2. But this outcome differs from the outcome of perfect
competition in two ways:
a) The monopoly captures the entire consumer surplus.
b) The increase in economic profit attracts even more
rent-seeking activity that leads to an inefficient
use of resources.
V. Monopoly Policy Issues
A. Gains from Monopoly
1. A single-price monopoly creates inefficiency and price
discriminating monopoly captures consumer surplus and
converts it into producer surplus and economic profit.
2. And monopoly encourages rent-seeking, which wastes
resources. But monopoly brings benefits.
a) Product innovation. Patents and copyrights provide
protection from competition and let the monopoly
enjoy the profits stemming from innovation for a
longer period of time.
b) Economies of scale and scope. Where economies of
scale or scope exist, a monopoly can produce at a
lower average total cost than what a large number of
competitive firms could achieve.
B. Regulating Natural Monopoly
1. When demand and cost conditions create natural
monopoly, government agencies regulate the monopoly.
a) Figure 12.11 (page 273) shows a natural monopoly and
compares two types of regulation with no regulation.
b) Left alone, the natural monopoly will charge a price
and produce at a quantity where MR = MC. Price will
exceed marginal cost and quantity will be less than
under perfect competition.
2. Regulating a natural monopoly in the public interest
sets output where MB = MC and the price equal to
marginal cost. This regulation is the marginal cost pricing
rule, and it results in an efficient use of resources.
a) With price equal to marginal cost, ATC exceeds price
and the monopoly incurs an economic loss. If the
monopoly receives a subsidy to cover its loss, taxes
must be imposed on other economic activity, which
create deadweight loss.
b) Where possible, a regulated natural monopoly might
be permitted to price discriminate to cover the loss
from marginal cost pricing.
3. Another alternative is to produce the quantity at which
price equals average total cost and to set the price
equal to average total cost—the average cost pricing rule.